How Bruce Berkowitz stumbled with AIG

FORTUNE — With AIG stock cratering nearly 50% this year, all eyes have turned to investor Bruce Berkowitz, AIG’s largest private shareholder. The 52-year-old fund manager looked especially smart last year while amassing 40 million shares of the insurance giant. Back then, AIG shares were skyrocketing and embarrassing hedge fund managers like Steve Eisman who were betting on the stock’s collapse.

Bruce Berkowitz

Berkowitz was mum on AIG AIG this year until yesterday, when the Wall Street Journal first reported that he took his lumps and told his investors in a conference call that he had made a critical error. Instead of the U.S. Treasury selling its huge 92% stake in AIG — about 1.7 billion shares worth — for prices near AIG’s book value (upwards of $47 a share), Berkowitz said he now expects the government to sell them closer to the current market price of $27-$29 a share. The significance of his miscalculation is obvious: instead of potentially supporting AIG’s share price in the mid-$40s, the U.S. Treasury’s share sale is likely to depress the value of Berkowitz’s own stake, which includes shares purchased at prices ranging from the mid-$20s to mid-$40s.

It became apparent last year that the government would begin unloading its stake in the first half of 2011. But at the end of 2010, when AIG shares traded above $50, it looked as if the sale would produce a tidy profit. Berkowitz said as much in a December Q&A with Fortune:

The government had a pretty good record selling its shares in Citi without hurting the stock price. Do you think that will happen with AIG?

Yes, I do. If the marketplace understands that the Treasury is not going to be forced to sell its position at a poor price, then the value of the company will start to be judged based upon its intrinsic value rather than a constant focus on the stock overhang. I mean, if you take a look now at the amount of the government shares, the government is going to do great. 1.66 billion shares at $46 is a lot more than they’re owed.

Why he turned out to be wrong on the U.S. Treasury’s sale is a complicated question. It may be that Berkowitz overestimated his influence as the insurer’s largest private shareholder.

Previous interviews with Fortune indicate as much. First, Berkowitz didn’t anticipate that the government would own more than 80% of the company, which he interpreted to mean about 700 million shares. It currently owns 1.7 billion shares.

Furthermore, Berkowitz expected to have some say with AIG’s board after amassing a huge 32% stake in AIG’s non-government controlled shares. Last year he and his partner, Charlie Fernandez, pushed AIG to trade its tax losses for the government’s shares. Since AIG posted $100 billion in net operating losses over the past few years, it won’t have to pay taxes on its next $100 billion in profits. That could be a decade or more during which AIG doesn’t have to pay a dime to Uncle Sam, and Berkowitz figured the government might like to collect a tax bill in exchange for its stake. But the plan fizzled.

There are a couple reasons why Berkowitz doesn’t look cornered just yet. First, the Treasury still hasn’t started selling its stake. AIG is taking to the road this week to entice prospective investors. If the Treasury can’t sell the shares for its break-even price (around $29) it could simply wait until AIG’s stock rises. The stock has been pummeled recently after disappointing 2010 earning results and an unanticipated rise in expected insurance claims. But better results in 2011 and 2012, and increased stock ownership when more shares are available, could eventually move the stock closer to its book value of roughly $47. Berkowitz’s Fairholme fairx fund is sitting on 21.5 million AIG stock warrants with a strike price of $45, in addition to 40.4 million common shares as of Feb. 28 this year.

On the conference call with investors, Berkowitz ended his prepared remarks on AIG with a curious quote attributable to two value-investing luminaries. “Benjamin Graham and David Dodd said many shall be restored,” Berkowitz said. Whether AIG is rehabilitated remains to be seen. But increasingly it looks as if Berkowitz’s sterling long-term record will depend on it.